Using Contractors? There’s a New Classification Rule You Should Know About.

Using independent contractors can be a great way for a small business to access the specialty skills necessary for going to market and growing.

But there are important legalities to know and comply with when it comes to independent contractors. Most recently, the Department of Labor issued a final rule that went into effect March 11 for determining whether a worker should be classified as an independent contractor or an employee. 

It can be tough to know how to interpret the rule, so we’re here to help shed as much light on it as we can.

The difference between employees and independent contractors

Let’s start with the basics. An independent contractor is a self-employed person or entity that performs work services on a contracted basis, usually through W9 and various 1099 tax forms. Employees, on the other hand, are directly employed by an employer, usually through W2 tax forms.

What’s led to the concern over proper classification of workers is that employees are entitled to certain rights or benefits that independent contractors aren’t. Laws like the Family and Medical Leave Act, for example, only apply to employees. Employers pay a portion of their employees’ Social Security and Medicare taxes while independent contractors are on the hook for the full amount themselves.

The new rule’s six-point classification system

The way that the Department of Labor’s new rule determines worker classification is through an economic realities test. It offers six factors for analyzing economic realities:

• An opportunity for profit or loss depending on managerial skill. Does the worker have the opportunity to make profits or suffer losses based on their business judgment?
• Investments by the worker and potential employers. Is the worker making investments in their business?
• The work relationship’s degree of permanence. Is the work relationship at hand an ongoing or continuous one that’s exclusive to work for other clients or companies?
• The nature and degree of control. Does the potential employer have control over the work, like how, where, and with what equipment it’s performed?
• The extent to which the work performed is an integral part of the potential employer’s business. Is the work that’s done central to the potential employer’s business?
• Skill and initiative. Does the worker have and deploy special skills or do they rely on training from the potential employer?

The final rule on the Federal Register offers more detailed guidance on how to apply these six factors to determine the classification of a working relationship.

Unlike the previous 2021 rule, this new rule takes the totality of all six factors into equal consideration, but additional factors can be considered relevant as well.

The risks of misclassification

Employers can face both criminal penalties and financial liabilities in the form of back taxes and back wages stemming from misclassification of workers.

These can be failures to pay overtime and minimum wages under the Fair Labor Standards Act and penalties for failing to withhold and pay state and federal payroll taxes to violations for not keeping proper employer verification documents like I-9 forms. However, this new rule doesn’t change or impact other laws, state or federal, that use other standards for determining worker classification.

Staying as compliant as possible

By now, you might be feeling the way a lot of people are—confused about what the right way forward is and worried about unintended liabilities. The best place to go for quality, customized information is your HR department and legal council. The people who know your business best are in the best position to help.

Beyond that, now is a good time to review the contracts you have with independent contractors for potential DOL rule violations. If you don’t use independent contractors, keep this information in mind for the future. If you do use contractors and you don’t know how to proceed with a contract review, now is likely a good time to get professional HR or legal advice on the matter—an investment now could potentially save your small business a lot down the road.